Wealth maximization and profit maximization are both objectives that companies seek to fulfill. Profit maximization is based on the overall economic activity of a business entity that is aimed at achieving greater profitability. It is premised on the understanding that a business cannot survive without making any profits. The profits are used to cover the expenses incurred by a company and help to finance future growth and expansion. However, the profit maximization approach is considered old-fashioned and narrow-based.
In addition, it does not factor the time value of money as well as the scheduling and amount of earnings. Profit maximization is aimed at reducing expenses as much as possible such that a company may not include hedging as an expense against the future decline in business performance. Also, while seeking to make more profits, a company may not pay attention to critical stakeholders, such as employees and suppliers, who contribute to the growth of the company.
The wealth maximization approach comes in to defeat the shortcomings of the profit maximization approach. Wealth maximization aims to increase the shareholder’s value in a company. The increase in shareholder wealth is principally achieved through increasing the share price, which indicates the progress of the growth of a company. Wealth maximization involves discounting factors in the time value of money that are effective in comparing and showing the pace of growth over time. Another benefit of wealth maximization is that it involves risk mitigation measures, such as hedging, which help the company to mitigate itself against future losses.
More (2019) states that the wealth maximization approach takes into consideration various stakeholders’ issues through enacting proper corporate social responsibility agenda. It is also preferred because it enables the firm to efficiently allocate the available resources, which ultimately promotes efficient use of capital. The wealth maximization approach is based on the company’s cash flow as opposed to the profit maximization approach that works through the accounting profit as the basis for making decisions.
Relying on accounting profit is not meaningful since it is uncertain, and it can be interpreted in different ways by different people. However, the cash flow approach is clear since it involves adding all non-cash expenditures to the profit after tax.